Hardware Costs Tell on Google's Q2

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Google Inc (GOOG) reported earnings of $8.53, missing our estimates by 22 cents, or 2.5% (in line with the Zacks earnings expected surprise prediction of -2.5%). Revenue beat by a wide margin.

Historically, Google has done much better than Yahoo Inc (YHOO), which has been struggling to hold its own, and Microsoft Corp (MSFT), which has yet to gain critical mass. Google’s superior algorithms have consistently attracted more users and generated better conversions.  However, the last quarter had a few moving parts, given the Nexus 7 launch and the inclusion of Motorola.

Revenue

Google’s gross revenue touched a record $12.21 billion, representing sequential and year-over-year increases of 14.7% and 35.3%, respectively. Excluding the $1.25 billion contribution from Motorola, revenue was up 3.0% sequentially and 21.5% from the year-ago quarter.

Google is very strongly positioned in the mobile segment, where both smartphones and tablets have been making strong headway. The dominant position has enabled Google to generate very strong mobile revenue growth. In fact, the company’s position in mobile looks better than it was in traditional computing, which says something about its strategic planning and execution.

Additionally, Google continues to benefit from the secular shift in advertising spending from offline to online properties, increasing contribution from medium and small-sized advertisers, success of the DoubleClick ad exchange, improving search algorithms and better ad quality.

Revenues from both Google-owned and partner sites continued to grow double-digits on a year-over-year basis (they have grown double-digits each quarter over the last few years). Google websites accounted for around 62% of quarterly revenue, while partner sites accounted for another 24%. Total advertising revenue was up 3.0% sequentially and 20.8% year over year. Google-owned sites were stronger than partner sites in the last quarter.

Total traffic acquisition costs, or TAC (the portion of revenue shared with Google’s partners and amounts paid to distribution partners and others who direct traffic to the Google website), was down 16.0% sequentially, although it continued to increase (up 24.5% from last year). However, we do not consider this a reason for concern since the traffic acquisition cost as a percentage of total advertising revenue went up 13 basis points (bps) sequentially and 52 bps from the year-ago quarter.

While both items in TAC went up in the last quarter, distribution payouts were up more significantly. Net advertising revenue, excluding TAC was up 2.8% sequentially and 19.9% year over year.

Licensing and other fees brought in the remaining 4% of revenue in the last quarter, up 3.3% sequentially and 41.6% from the June 2011 quarter.

The Hardware and Other segment (mainly Motorola, but also Nexus 7) accounted for 10% of revenue in the last quarter, with 67% coming from mobile products and the balance from home products.

Total revenue excluding total traffic acquisition costs came in at $9.62 billion, 14.4% higher than the Consensus Estimate of $8.41 billion.

The U.S. generated around 51% of revenue, up 28.3% sequentially and 50.5% from a year ago. The U.K., with a 10% revenue share was up 3.1% sequentially and 21.5% from last year. Other markets accounted for the remaining 39% of revenue, representing sequential and year-over-year increases of 14.7% and 35.3%, respectively.

Google stated that the U.S., Canada, Asia/Pacific and Northern Europe did well in the last quarter, with Southern Europe slowing slightly due to macro concerns and a weak ad market in Spain. Motorola derives more than half its revenue from the U.S. and has a limited presence in the U.K. Therefore, both the U.S. and other international markets gained from the addition of Motorola’s results in the last quarter.

Margins

The gross margin of 59.0% declined significantly from both the previous and year-ago quarters, due to the much lower margins of Motorola’s hardware business. The standalone Google gross margin was 63.7% (down 71 bps and 116 bps, respectively from the previous and year-ago quarters) compared to standalone Motorola’s 17.7%.

The advertising gross margin was the combined effect of revenue growth, a 1% sequential (42% year-over-year) increase in the number of paid clicks, and a 1% sequential increase (16% year-over-year decline) in the cost per click.

The number of paid clicks and cost per click appears significant, as they are indicative of higher volumes coming at lower prices. The mobile and emerging markets businesses are growing strongly and distribution costs are increasing, which could be the reasons.

Other costs, associated with data center operation, amortization of intangible assets, content acquisition, credit card processing and manufacturing and inventory-related costs increased significantly as a percentage of sales, which also negatively impacted the gross margin in the last quarter.

Operating expenses of $3.91 billion were higher than the previous quarter’s $3.47 billion. The operating margin was 27.0%, again impacted by the higher hardware-related costs. R&D and S&M were down as a percentage of sales from both the previous and year-ago quarters, with G&A increasing slightly from both periods.

Non-operating gains were $254 million, up from $156 million in the previous quarter and $204 million in the June 2011 quarter. Google had some investment gains in the last quarter, which more than offset the impact of lower interest income and FAS 133-related expenses.

Google reported net income of $2.82 billion, or 23.1% of sales, compared to $2.89 billion, or 27.1% of sales in the March 2012 quarter and $2.51 billion, or 27.8% of sales in the year-ago quarter. GAAP earnings of $8.42 a share were down from $8.75 in the previous quarter and $7.68 in the June quarter of 2011. Excluding $89 million (11 cents a share on a tax-adjusted basis) for severance and benefit arrangements related to the Motorola acquisition, the pro forma EPS was $8.53 a share. There were no special items in the previous and year-ago quarters.

Balance Sheet

Google has a solid balance sheet, with cash and short term investments of nearly $43.12 billion, down $6.19 billion during the quarter. The company generated around $4.25 billion from operations in the last quarter and spent $774 million on capex, netting a free cash flow of $3.48 billion.

Our Take

Google generates revenue primarily from the sale of advertising space on its online properties. It has therefore focused on protecting and growing its position in the search market through continued innovation and quality improvements. This focus has ensured that it remains the dominant player in search, not just in the traditional computing segment, but even more so in the emerging mobile space.

Google’s Android OS has gone a long way to cementing its position in mobile. Google has also made acquisitions over time that have augmented its in-house capabilities.

With the growing importance of social networking, Google introduced Google Plus. While some have commented that Google will not be as popular as Facebook (FB), this is really not that much of a concern and remains to be proved. In the meantime, it is obvious that social data will be an additional tool for Google, which has been making a number of acquisitions and innovations in the space. Management has stated that social relevance in search is resulting in better conversions and the company’s success in the display format is well borne out by the latest eMarketer estimates.  

Toward the end of last year, Google stepped up efforts targeting the small and medium business (SMB) segment. The SMB segment has played a key role in elevating Google’s position in display and we expect the company to continue chipping away at Yahoo’s market share.

Google’s success in display is very encouraging, since display advertising is expected to grow very strongly over the next few years, surpassing search advertising by 2015. While Facebook is expected to maintain a slight edge this year, Google is expected to become the display market leader next year.

Despite the initiatives to drive growth and superb execution to date that have enabled the company to maintain share in a fast-growing market, Google’s share prices have dropped 10.9% since the beginning of the year. This could be because of its many legal entanglements related to competitive matters.

While prices responded positively to its second quarter results and some momentum may be in the shares, we expect them to remain range-bound over the next 1-3 months given margin concerns related to the hardware segment.

Google shares therefore carry a Zacks Rank of #3, implying a short-term Hold recommendation.

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